The path to gaming the Volcker Rule has always been clear: Banks will shut down anything with the word "proprietary" on the door and simply move the activities down the hall.

To look like they were ready to comply with the Volcker Rule, the part of the Dodd-Frank Act that aims to prevent banks from gambling on their own account with money that taxpayers insure, financial firms quickly spun off or shut down their hedge funds, private equity firms and proprietary trading desks.

But the suspicious-minded among us wonder whether it was all that simple. This is the specter raised by the news that a JPMorgan Chase trader in London, made instantaneously notorious thanks to his colorful nicknames ("Voldemort" or "the London Whale," take your pick), was amassing such huge positions in indexes related to corporate defaults that he was distorting the market. (Apparently, it wasn't just one trader but more than a dozen, according to a person at JPMorgan, but the nicknames are too good to let go.)

Bloomberg followed up with a powerful article about how Jamie Dimon, the chief executive of JPMorgan, has transformed the sleepy chief investment office, which takes care of the bank's treasury operation, into a unit that hires former hedge fund portfolio managers and slings around giant sums of money in what walks and quacks like prop trading. The chief investment office seems not to just be risk-mitigating, but profit-maximizing.

The Congressional authors of the Volcker Rule worried about this very thing, and you can trace their concerns through their drafts. The original language of the rule had a broad exception: banks couldn't trade for their own account, but they could hedge to mitigate their risks.

The authors quickly realized that the exemption was absurdly broad. After moving these businesses to other divisions, banks would then argue that their bets were either market-making activities or simply hedges that offset risks.

Such "hedges" could encompass a lot of trades that looked awfully proprietary. A trade could seem to hedge a large business risk, like suffering loan losses if companies they lent to went broke in an economic downturn. But that might just be a bet on companies going belly up.

So Congress tightened the language. It wrote that the hedges had to be specific. When the Dodd-Frank financial reform law came out, the Volcker Rule provision defined "risk mitigating activities" as trades that were "designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings." No macro-hedging, only micro-hedging. That is the will of Congress.

But then federal regulators got their hands on Volcker and set about interpreting the meaning of Dodd Frank. This has been a Talmudic exercise in reverse: It has taken the clear and simple intent and made it muddy and complicated.

Regulators decided that banks could say that they were hedging for an overall portfolio. And the banks could argue that a hedge was legitimate if it merely had a "reasonable correlation" with the security or position being hedged. It was as if the regulators had not only questioned the basis for the rules of being kosher, but had also served up a cheeseburger — with bacon on top — all very nonkosher.

"One of the great fears was that banks could avoid the rule by simply pretending that their prop trading was somehow their market-making or hedging," a Congressional aide told me. "Congress tightened the language to prevent this, and yet banks still may get away with this under the proposed rules."

The rules aren't finalized, so there's a chance the regulators will make adjustments. The authors of the Volcker Rule raised objections in a comment letter in February. "Banks could easily use portfolio-based hedging to mask proprietary trading," Democratic Senators Jeff Merkley of Oregon and Carl Levin of Michigan wrote in a letter to regulators. "There is no statutory basis to support the proposed portfolio hedging language, nor is there anything in the legislative history to suggest it should be allowed."

The problem of allowing a broad "portfolio hedging" exception is obvious. Follow the logic to its end, and you could expect to find a bank arguing that it needed to hedge its commercial banking business by buying an investment bank and hedge its banking business with an insurance company and so on.

And lo, JPMorgan says exactly what we might expect a bank that knows how the regulators are interpreting Volcker would say: that the trading of its chief investment office is merely hedging.

But the bank is unabashed: "The purpose of this is to hedge the macro risk of the company," a JPMorgan executive explained to me. "It's what we are supposed to be doing, we do it well, we write about it in the annual report and we show it to every regulator," he added.

Alas, it wasn't the regulators who brought this to light. Instead, it took hedge funds on the other side of trades. This has led to a cynical reaction: hedge funds are hardly the epitome of upright regulatory citizens, burning to bring violations of the Volcker Rule to light.

But just because a hedge fund is biased doesn't mean it's wrong. It can be simultaneously true that hedge funds have gotten themselves into a bad trade and that JPMorgan is doing something more than hedging.

And it matters what the banks' trading partners think because the banks invoke them constantly in order to protect themselves from the Volcker Rule. The big banks wrap themselves in the mantle of market-making. Without them, they warn, liquidity — or how easy it is to enter and exit trades — will dry up.

In the case of these JPMorgan trades, however, we can see how a huge position can undermine liquidity. A big bank can become the market. JPMorgan's big position now makes trading in these credit indexes less likely, not more, which could lead to more volatile markets.

So is this legitimate trading? The hedge funds don't really know what's going on at JPMorgan's chief investment office. Nor can the public tell from the bank's disclosures. The only ones who have a chance to get a true picture are the dozens of regulators who are sitting in the bank's office.

But given how bent the regulators are to subvert the will of Congress, it would take an act of extraordinary naiveté to believe they will actually get to the bottom of it.

18 comments

The TBTF banks will always find a way to do an end-run around legislation because they have pecuniary incentive to do so. The regulators, on the other hand, are under-resourced and can never compete in the compensation arms race. So the only real answer is to allow a credible threat of business failure, i.e. remove the government backstop.

A better question is why the regulators are making decisions on what the law covers. I don’t agree with Congress about much, but in no case should an unelected official be overriding the laws passed by our elected body of legislators.

Why isn’t Congress investigating the regulators? Or is Major League Baseball as far as they’re willing to dig? Or, if they’re turning a blind eye, why might that be?

This doesn’t even approach the “rolling long” commodities problem where, apparently, hundreds of billions of people need to be supplied with oil (i.e., alleged demand in futures for fuel and food are dozens of times the world consumption). In comparison, this Chase trading is positively adorable.

“Every firm in the industry has legal and compliance divisions whose primary purpose on paper is to ensure they are compliant with regulations. The vast amount of complexities in banking and finance law necessitates this. But the equally important duty of these legal teams is to find “creative” ways to get around laws and still be in compliance. Perhaps this would not be such a big deal if it did not have the negative impact on society that it does.”

The real question is - are these regulators left over from the Bush/Cheney Junta? In other words, given that virtually every bureaucrat appointed by Bush had the specific purpose of evading regulations & controls, and paralyzing the regulatory functions of every agency or bureau they were appointed to, are they continuing the purposeful destruction of the federal government that was begun as far back as 1980 - and accelerated from 2000 on? And, if so, why hasn’t Obama gotten rid of them? The damage done to the federal government by Bush was structural. Why hasn’t it been reversed?

As I see it, we have a situation where we have regulators who don’t regulate, but accomodate those who they are supposed to regulate. Could it be that the regulators in this case have a philosophical opposition toward regulation? It’s like sex in that people who don’t like it aren’t going to be very good at it. So, people who don’t like the concept of regulation aren’t going to be very good at doing it. Also, pardon my cynicism, but could money be a factor? It might be interesting to see what happens to regulators once they leave government service.

Forget “audacity of hope” and “change we can believe in” and “yes we can.” oh, and transparency also.
The regulators are part of the executive branch and the executive branch is too timid, too compromised, too worried about reelection or some combination of these to do anything about the “regulators.”
good heavens, better to have a Republican in the White House - the devil you know, rather than a smooth talking individual whose approach is based on glossy promises with no real commitment. The administration is loud and furious to criticize Republicans in Congress, yet nary a word about the “regulators.”

i agree with you Barbara,. both of us voted for obama lamma ding-dong and although he isn’t as bad as a gop, he is a long way from doing anything about this stuff. i tore my obama sticker off my car after about a month of waiting for him to send oil skimmers to the gulf in 2010. then after Reckless Endangerment was published and i learned about all the crooks that are in his cabinet i pooped a pink twinkie. although the crazy Ron Paul is nuts in deregulating everything i will vote for him if i can, because he is in my mind, uncorruptable, and i like his promise to bring all troops home from where ever in the hell they are across the globe. I know he’s got as much chance as a snow flake in hell. But so does Romney.

Just read Bernanke’s remark that the banks will need more time to prepare to meet the Dodd-Frank statute requirements; apparently they failed English 101 and have forgotten how to write a clear sentence. Joking of course! These odious people will lie, cheat and steal their way to success. For gods sake, Congress, step in and for just a little bit take your hand out of their pocket and fix this freight train of theft.

Pat—Romney was my governor and he elminated a $3 BILLION deficit he inherited, from a Democrat, all without raising taxes. He is a very honorable man and can’t be bought. He’s already filthy rich by his own making and good for him. Who would prefer as POTUS—Obama the amateur?!?

It’s not hard to give this oversight…thinking about hedge accounting like author mentions above where you gotta “staple” the long position to the hedge position for the files. Any loose-ness in definition of sufficient “correlation” between the 2 is pretty well expressed through math that’s become standard market lingo for decades for derivatives positions.
Trouble may be that the SEC/FED/CFTC don’t speak that language and doubt they’ve got spreaddsheets up showing things like “delta flat” which is best guess that long/short exposure is about even… helps traders sleep better at night. Jamie Dimon speaks fluent “delta” btw

but I’m improving myself. I absolutely enjoy reading everything that is written on your website.Keep the posts coming. I liked it!

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About The Trade

In this column, co-published with New York Times' DealBook, I monitor the financial markets to hold companies, executives and government officials accountable for their actions. Tips? Praise? Contact me at .(JavaScript must be enabled to view this email address)

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